How to set up an ICO – Part 1: The Fundamentals

Flag Theory Weekly Letter – Tuesday May 29th, 2018

At this point, ICOs do not need much presentation. A new model of crypto financing exploded in 2017 with more than 400 successful ICOs raising collectively more than $5.6 billion, this figure has already been surpassed in 2018.

Even sovereign nations are jumping on the Initial Coin Offering train, such as the infamous Venezuelan Petro or the recent announcement of the Marshall Islands government to issue its own legal tender cryptocurrency, the Sovereign, which we will discuss in the following letters.

At Flag Theory we receive dozens of daily requests from entrepreneurs who are interested or are going to launch an Initial Coin Offering.

That is why we are going to launch a series of six articles where we will review the entire process to properly set up an ICO, from corporate structuring and the token issuance to ongoing operations once the sale is concluded. So you’ll have an idea on all the steps and things to consider from a legal standpoint when launching an ICO.

These articles are just for illustrative purposes, it is not, nor intends to be legal or tax advice. Before taking action, always speak with an attorney. We have a global network of attorneys and accountants that we can refer you to in the relevant jurisdictions and can give you the proper advice according to your specific circumstances.

The Fundamentals

We assume that you are a hard-working entrepreneur backed by a strong team with a valid business idea and an MVP or marketed product which uses the blockchain.

We assume that you are not trying to ride the ICO wave only to get quick money. This is not a good idea, in addition to being morally dubious, you may end up having serious legal issues.

You have already decided to boost your business by launching an ICO. Now it’s time to build the foundations on which this ICO will be structured.

This is the most important decision of the entire process and the one that will mark the procedures to successfully set up an ICO.

Broadly speaking there are two types of tokens, utility tokens and security tokens.

A utility token may represent future access rights to a company’s product or service. A utility token is not designed to be an investment; we could compare it to a gift card or use rights or a software license. It is meant to provide some utility within a product, service, or network.

The second type of token is the security token. Security tokens are backed by assets and can represent equity, debt, dividend, ownership, voting rights or other assets. These tokens are subject to securities laws and regulations and they must be registered in the countries where the investors are located.

For the purpose of this series of articles, we will assume that you are going to launch a UTILITY token. In future report series, we will go into the issuance of a security token but for now we will leave it aside.

If you are issuing an ERC-20 utility token, don’t publicly call your token issuance an ICO and your token a ‘coin’ or ‘cryptocurrency’. These terms are a misnomer and could draw attention to regulators.

If you are not offering any equity or future rights to profit in the company and are simply issuing a utility token which grants rights to a network, you might want to call it a “token” and call it a TGE (token generation event), a TDE (Token Distribution Event) or a Token Sale. It might be less sexy but it is a far more accurate description of what you are doing

If you are launching a new blockchain, perhaps a coin or cryptocurrency is more of a proper name, but if you are going to launch a utility token, ask yourself if the software you are building on top of the blockchain really needs an entirely new chain (and all the complications therein) it or if you are really building on the application layer of an existing chain.

The Token Economy

A utility token must fulfill a necessary mechanism for utility within the platform, ideally from day one. Various regulators have strongly suggested that tokens which do not provide immediate utility are more like a security (if they trade without providing utility).

The utility of the token within the network, whether it is an access right, membership, unlocking functionalities, payment for services, discounts, etc. should be examined in their own right, specific to your project, by lawyers.

Broadly speaking, however, and as the name suggests, a UTILITY token must have a UTILITY in your application or network.

If the token is created only as a financing tool, consider launching a security token offering (STO) instead.

It is paramount that the token economy design makes sense and is viable, not only from a legal standpoint, but also for the long-term success of the ecosystem that you are building.

You have to consider various different aspects of the token, such as velocity. The token velocity influences the long-term, non-speculative value of a token. Incorporating mechanisms to encourage your token holders to hold your tokens will reduce velocity.

A low velocity will help to get a long-term and feasible utility token marketplace. For this purpose, for example you can consider including staking mechanisms in your token economy.

Legal Planning for your ICO

You already have a studied and solid business model and plan, the necessary technical specifications written in your technical whitepaper, including a sound and feasible utility token economy and a distribution plan with the token metrics. You have also build an MVP and have a proven track-record before launching the token sale.

Now you need to surround yourself with a strong legal team.

Keep in mind that depending on your token nature you might be subject to different laws, including, but not limited to, commodities laws (e.g. if your token represents an underlying asset), money transmitter laws (e.g. if you provide brokerage services between buyers and sellers) or crowdfunding laws.

The token structure and economy discussed above must go through the legal filter to make sure you are a truly UTILITY token and you are not breaking any existing law of offering something which is actually a security.

Your legal team must also review each asset of the project, from the whitepaper to your public communications. You need to overcome all the legal hurdles and not get into potential issues that launching a token sale may entail.

There is a lot of regulatory uncertainty in the blockchain space and you’ll want various advisors in different jurisdictions in order to make sure you are covered and in line with existing laws.

Next we will pick the most advantageous jurisdictions to set up a robust corporate structure and prepare the terms and conditions of your token sale. We’ll talk about this in the next articles. Stay tuned.

If you are planning to set up an ICO, we can help you. We assemble teams to help with all of the legal, tax, compliance and banking issues you need to be aware of for both your company and its officers.

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NOTICE: The contents of this article are not to be considered as a legal opinion or tax advice and should not be relied upon as such. Far Horizon Capital Inc does not hold itself out as a legal or tax advisor. If you wish to receive a legal opinion or tax advice on the matter(s) in this article please contact our offices and we will refer you to an appropriate legal practitioner. Use of our website FlagTheory.com is subject to our terms and conditions.